lin and hwang - 2010 - audit quality, corporate governance, and earnings management

Specifically,for corporate governance, the independence ofthe board of directors and its expertise have anegative relationship with earnings management.Similar negative relationships exi

Audit Quality, Corporate

Governance, and Earnings

Jerry W Lin1and Mark I Hwang2

1 University of Minnesota Duluth

2 Central Michigan University

Earnings management is of great concern to corporate stakeholders While numerous studies have investigated the effects of various corporate governance and audit quality variables on earnings management, empirical evidence is rather inconsistent This meta-analysis identifies 12 significant relationships by integrating results from 48 prior studies For corporate governance, the independence of the board of directors and its expertise have a negative relationship with earnings management Similar negative relationships exist between earnings management and the audit committee’s independence, its size, expertise, and the number of meetings The audit committee’s share ownership has a positive effect

on earnings management For audit quality, auditor tenure, auditor size, and specialization have a negative relationship with earnings management Auditor independence, as measured by fee ratio and total fee, is also a deterrent to earnings management.

Key words: Audit committee, audit quality, auditor choice,

corporate governance, earnings management, fraud,independence, meta-analysis

SUMMARY

Earnings management is of great concern to

corporate stakeholders While numerous studies

have investigated the effects of various corporate

governance and audit quality variables on earnings

management, empirical evidence of their effects

is rather inconsistent This paper applied

meta-analytic techniques to empirical data from

48 studies that examined relationships between

corporate governance and audit quality variablesand earnings management Of the 17 relationshipstested, 12 showed significant effects Specifically,for corporate governance, the independence ofthe board of directors and its expertise have anegative relationship with earnings management.Similar negative relationships exist betweenearnings management and the audit committee’sindependence, its size, expertise, and the number

of meetings The audit committee’s shareownership is positively related to earningsmanagement For audit quality, auditor tenure,auditor size, and auditor specialization have a

Correspondence to: Jerry W Lin, Department of Accounting,

University of Minnesota Duluth, 1318 Kirby Drive, LSBE-360F,

Duluth, MN 55812, USA Email: jlin@d.umn.edu

ISSN 1090-6738

© 2009 Blackwell Publishing Ltd, 9600 Garsington Rd, Oxford OX4 2DQ,

negative relationship with earnings management.

Auditor independence, as measured by fee ratio

and total fee, is also a deterrent to earnings

management

Relationships that were non-significant include

the effects of the board of directors’ stock

ownership, existence of an audit committee, and

the separation of the board chairperson position

from the CEO position These are potential areas

for future research Another prospective research

stream is to examine the moderating effect of

certain variables such as country For example, we

found that while the independence of the board of

directors is significant overall, the effect is more

profound in countries other than the United States

The opposite is observed about the independence

of the audit committee: the effect is more

pronounced in the United States than in other

countries Similarly, the effect of auditor size as

a deterrent to earnings management is more

significant in the United States than in other

countries In fact, the effect is not significant when

data from other countries are tested On the other

hand, the share ownership of the board of directors

has no significant effect on earnings management,

in either the United States or other countries

We also tested the effects of two levels of

audit committee independence (complete and

proportional independence), and found both to

have a significant effect in reducing earnings

management Similarly, future research can

examine the moderating effect of important

regulations, such as the Sarbanes-Oxley Act, by

comparing data from pre- and post-SOX

INTRODUCTION

Much research has been conducted on the

determinants of earnings management such as

a firm’s financial characteristics, corporate

governance and audit quality However, the extant

studies have reported mixed results The purpose

of this paper is to use meta-analysis techniques to

synthesize and evaluate the findings from the large

number of existing studies on the determinants of

earnings management Our focus is on the effect

of corporate governance effectiveness and audit

quality Meta-analysis is the application of statistical

methods to a large collection of results from

existing individual studies for the purpose of

integrating and evaluating the research findings

Use of meta-analysis often makes it possible to

reach stronger conclusions or more valid inferences

about a common research issue than in a narrativeliterary review (Wolf, 1986) The remainder of thispaper is organized as follows The next sectionprovides an overview of prior research on therelationships between earnings management andcorporate governance and audit quality Next, wedescribe the research methodology, followed bydiscussions of meta-analytic results The last sectionpresents concluding remarks

LITERATURE REVIEW

Earnings management

Various definitions exist for earnings management.Schipper (1989) appears to have captured theessence of earnings management by defining it as

‘purposeful intervention in the external financialreporting process with the intent of obtainingprivate gain’ Likewise, Healy & Wahlen (1999)state that ‘earnings management occurs whenmanagers use judgment in financial reporting and

in structuring transactions to alter financial reports

to either mislead some stakeholders about theunderlying economic performance of the company

or to influence contractual outcomes that depend

on reported accounting numbers.’ Regardless ofthe definition adopted, earnings management isinherently unobservable Most prior studies usevarious measures of discretionary or abnormalaccruals as proxies for earnings management Othermeasures used include earnings restatement andfinancial reporting fraud A regression model istypically employed to investigate the effects ofvarious independent variables on earningsmanagement in the form of:

where EM is earnings management and X i

represents either a control variable or anindependent variable under investigation in study

k in a set of N prior studies in a meta-analysis Next,

we provide an overview of research on the effects

on earnings management of factors relating tocorporate governance effectiveness and quality ofexternal audit

Corporate governance

Owing to the separation of ownership and control(and the resulting agency problems) in the modernbusiness world, a system of corporate governance

is necessary, through which management is

overseen and supervised to reduce the agency

costs and align the interests of management with

those of the investors While there is no generally

accepted definition, corporate governance may be

defined as a system ‘consisting of all the people,

processes and activities to help ensure stewardship

over an entity’s assets’ (Messier et al., 2008: 36).

A good corporate governance structure helps

ensure that the management properly utilizes

the enterprise’s resources in the best interest of

absentee owners, and fairly reports the financial

condition and operating performance of the

enterprise For corporations in the US, the body

primarily responsible for management oversight

is the board of directors and its designated

committees The audit committee, consisting of

members of the board, assists the board in its

oversight of the financial reporting process

The role of the corporate governance structure in

financial reporting is to ensure compliance with

generally accepted accounting principles (GAAP)

and to maintain the credibility of corporate

financial statements The corporate governance

mechanisms that are the focus of recent regulations

and prior studies are attributes related to the

organization and functioning of the board in

general and its audit committee in particular

Properly structured corporate governance

mechanisms are expected to reduce earnings

management because they provide effective

monitoring of management in the financial

reporting process

Unfortunately, empirical research to date

provides inconsistent evidence on the relationship

between measures of corporate governance

effectiveness and earnings management (earnings

quality or the lack thereof) For example, while

Davidson et al (2005) and Klein (2002) report

a significantly negative relationship between

board independence and earnings management,

Park & Shin (2004) and Peasnell et al (2005) fail

to find any significant relationship Such

inconsistency also exists in empirical evidence on

the relationships between earnings management

and other attributes related to board effectiveness

in monitoring management in the financial

reporting process

Often the board of directors delegates work

on important tasks to its standing committees

For example, the audit committee is charged

with overseeing financial reporting The audit

committee’s primary role is to help ensure high

quality financial reporting by the firm Therefore,

a properly structured and functioning auditcommittee is expected to reduce opportunisticearnings management A number of recent studiesexamine the effect of an audit committee’scharacteristics on earnings management but haveprovided mixed evidence as is the case in research

on effectiveness of the board of directors inreducing earnings management For example,

while Abbott et al (2000) document that occurrence

of earnings management decreases with

independence of the audit committee, Choi et al (2004) find no such effect Also, Xie et al (2003) find

no significant association between the number ofdirectors on the audit committee and earnings

management Similarly, Abbott et al (2004) find

no impact of audit committee size on earningsrestatements In contrast, Yang & Krishnan (2005)report that audit committee size is negativelyassociated with earnings management (usingabnormal accrual as proxy), implying that a certainminimum number of audit committee membersmay be relevant to quality of financial reporting.There is also concern that compensating auditcommittee directors with stock and stock optionsmay result in impairment of their independence(Millstein, 2002); however, empirical evidence on

this issue has been limited until recently Bédard et

al (2004) document that the more stock options that

can be exercised in the short run relative to the total

of options and stocks held by audit committeedirectors, the higher the likelihood of aggressiveearnings management Yang & Krishnan (2005)report that stock ownership by board members

on the audit committee is positively associatedwith earnings management These resultscontradict the findings by Beasley (1996) thatthe likelihood of fraud decreases as stockownership by outside directors (not necessarilyaudit committee directors) on the board increases

Audit quality

The agency problems associated with theseparation of ownership and control, along withinformation asymmetry between management andabsentee owners, create the demand for externalaudit External auditors are responsible forverifying that the financial statements are fairlystated in conformity with GAAP and that thesestatements reflect the ‘true’ economic conditionand operating results of the entity Thus, theexternal auditor’s verification adds credibility to

the company’s financial statements Also, the

external auditors are required by auditing

standards to discuss and communicate with the

audit committee about the quality, not just the

acceptability, of accounting principles applied

by the client company Therefore, a quality audit

is expected to constrain opportunistic earnings

management as well as to reduce information risk

that the financial reports contain material

misstatements or omissions

The guidelines and measures for the quality of

the external auditor’s performance are set forth

in generally accepted auditing standards, such as

competence, independence and exercise of due

professional care Obviously, the quality of the

auditor’s performance is multi-dimensional as set

forth in the auditing standards, and differences

in audit quality are to be expected ‘Audit

quality differences result in variation in credibility

offered by the auditors, and in the earnings quality

of their audit clients Because auditor quality is

multidimensional and inherently unobservable, no

single auditor characteristic can be used to proxy

for it’ (Balsam et al., 2003: 71) Since audit quality

may be affected by a number of factors, it is not

surprising that researchers have used various

measures to proxy for audit quality in prior studies

For example, researchers have examined the

effects of auditor brand name (auditor size) and

industry specialization, auditor tenure, provision

of various services by the auditor and auditor

independence on a number of issues directly or

indirectly related to financial reporting Empirical

evidence on these audit quality measures has been

mixed For example, while many existing studies

show that the use of brand name (i.e., Big 4/5/6)

auditors reduces earnings management (e.g.,

Becker et al., 1998; Francis et al., 1999; Lin et al.,

2006), many others fail to report such findings (e.g.,

Bédard et al., 2004; Davidson et al., 2005) As

another example, Frankel et al (2002) report that

the ratio of non-audit service fees to total auditors’

fees (proxy for impaired auditor independence) is

positively associated with small earnings surprises

and with the magnitude of discretionary accruals

(proxies for earnings quality or earnings

management) Their results provide support to the

SEC’s position that non-audit fees can impair

auditor independence and hence audit quality

On the other hand, Chung & Kallapur (2003) find

no significant relationship between discretionary

accruals and audit fees or non-audit fees Similarly,

Raghunandan et al (2003) find no evidence

supporting the claim that non-audit fees or totalfees inappropriately influence the audit of financialstatements that are subsequently restated.Inconsistent results reported in prior studies aboutthe effects of the other factors affecting auditquality on earnings quality are highlighted in theresults section below

METHODOLOGYThe first step in a meta-analysis is to locate relevantstudies through computer and manual searches.Various combinations of key words are used tosearch commonly available computerized literaturedatabases, such as ABI/Inform and BusinessSource Premier, to locate empirical (archival)studies that deal with earnings management Keywords used include earnings, accrual, restatement,fraud, management, quality, audit and governance.The computer searches were conducted from lateOctober to early November 2007 and publicationsavailable online or in print were then reviewed forpossible inclusion References in studies identified

in computer searches were also scanned to findadditional studies Published articles had to beempirical archival studies that met all of thefollowing criteria for inclusion in the meta-analysis:(1) the dependent variable must be measures based

on abnormal (discretionary) accrual, financialstatement restatement or reporting fraud; (2) theindependent variables in the empirical multivariatemodel must include measures of audit quality, oreffectiveness of corporate governance relating tothe board of directors or audit committee; and (3)

the test statistics or p-value needed to compute the

effect size must be reported

Ultimately, 48 studies were included in themeta-analysis Table 1 lists these studies and alsoprovides information about the dependent andindependent variables, and data years andcountries for sample firms used Many of theseincluded studies measure the same variable inmultiple ways For example, audit committeeindependence can be measured by its membershipthat is made of 100 percent outsiders (i.e.,completely independent) or over 50 percentoutsiders (i.e., proportionally independent) (Klein,2002) Multiple results from the same study arecombined to satisfy the independent samplerequirement for meta-analysis We also examinesample size, data years and countries used in theincluded studies to ensure no later studies useidentical data from any of the prior publications A

Table 1: Studies included

Abbott et al 2000 audit committee characteristics fraud US 1980–96

Abbott et al 2004 audit committee characteristics restatement US 1991–99

Agrawal & Chadha 2005 auditor fees; board & audit committee

characteristics

restatement US 2000–01

Antle et al 2006 auditor fees abnormal accrual UK 1994–2000

Ashbaugh et al 2003 non-audit service abnormal accrual US 2001

Balsam et al 2003 auditor specialization abnormal accrual US 1991–99

Bauwhede et al 2003 auditor size discretional accrual Belgium 1991–97 Bauwhede & Willekens 2004 auditor size discretional accrual Belgium 1994–96 Beasley 1996 audit committee characteristics fraud US 1979–90

Becker et al 1998 audit committee and BOD characteristics abnormal accrual US 1993

Bédard et al 2004 audit committee characteristics abnormal accrual US 1996

Benkel et al 2006 BOD & audit committee characteristics discretional accrual Australia 2001–03 Carey & Simnett 2006 audit partner tenure abnormal accrual Australia 1995

Chen et al 2005 auditor size & specialist discretional accrual Taiwan 1999–2002

Choi et al 2004 audit committee characteristics abnormal accrual Korea 2000–01

Chung et al 2005 audit committee & BOD characteristics abnormal accrual US 1980–96

Cormier & Martinez 2006 BOD & auditor size discretional accrual France 2000–02

Crutchley et al 2007 BOD characteristics fraud US 1991–2002

Davidson et al 2005 audit committee characteristics abnormal accrual Australia 2000

Ferguson et al 2004 non-audit service abnormal accrual UK 1996–98

Firth et al 2007 board characteristics & auditor size discretional accrual China 1998–2003

Francis et al 1999 auditor size discretionary accrual US 1975–94

Frankel et al 2002 non-audit fee abnormal accrual US 2001

Gul et al 2002 audit committee characteristics abnormal accrual Australia 1992–93

Hoitash et al 2007 auditor fees & size discretional accrual US 2000–03

Huang et al 2007 auditor fees & size discretional accrual US 2003–04

Jaggi & Leung 2007 BOD characteristics & auditor size discretional accrual Hong Kong 1999–2000 Jaggi & Tsui 2007 BOD characteristics discretional accrual Hong Kong 1995–99 Jeong & Rho 2004 auditor size discretional accrual Korea 1994–98 Kao & Chen 2004 BOD size & characteristics discretional accrual Taiwan; year not

reported Klein 2002 audit committee and BOD characteristics abnormal accrual US 1992–93

Krishnan 2003a auditor specialization abnormal accrual US 1989–98

Lee et al 2006 corp governance discretional accrual US 1991–2004

Lin et al 2006 audit committee characteristics restatement US 2000

Maijoor & Vanstraelen 2006 auditor size discretional accrual France, Germany, UK

1992–2000 Menon & Williams 2004 audit committee characteristics abnormal accrual US 1998–99

Myers et al 2003 auditor tenure abnormal accrual US 1988–2000 Park & Shin 2004 board characteristics abnormal accrual Canada 1996–97

Peasnell et al 2005 audit committee & board characteristics abnormal accrual UK 1993–96

Piot & Janin 2007 audit committee & auditor characteristics discretional accrual France 1999–2001

Raghunandan et al 2003 non-audit fee restatement US 2001

Rahman & Ali 2006 BOD & audit committee char and

auditor size

discretional accrual Malaysia 2002–03 Reitenga & Tearney 2003 BOD & audit committee characteristics discretional accrual US 1987–96

Reynolds et al 2004 auditor fees & size discretional accrual US 2000

Van der Zahn & Tower 2004 audit committee characteristics abnormal accrual Singapore 2000–01 Yang & Krishnan 2005 audit committee characteristics abnormal accrual US 1996–2000 Note: Studies included must meet all of the following criteria:

1 The dependent variable must be measures based on abnormal (discretionary) accrual, financial statement restatement or reporting fraud.

2 The independent variables in a multivariate model must include measures of audit quality and effectiveness of corporate governance relating to the board of directors and audit committee.

3 The test statistics or p-value for computing the effect size must be reported.

large number of studies are excluded from the

meta-analysis because they do not meet the criteria

specified above Table 2 lists these excluded studies

and states the reason for their exclusion

Following prior meta-analysis studies in

accounting (e.g., Hay et al., 2006; Kinney & Martin,

1994), we use the Stouffer combined test to

summarize the effects on earnings management of

various independent variables, which are reported

with a t-statistic, c2-statistic, or p-value in individual

existing studies We convert all t-statistics and

c2-statistics to their corresponding p-values and

then to Z-statistics as the measure of effect size The

individual Z-statistics are then combined using the

following formula (Wolf, 1986: 20):

N

where N is the number of studies under review.

It may be argued that not all studies in a

meta-analysis should be given equal weight Some

studies may use a small sample, while others

may be based on a much larger sample In the

unweighted case, as is the case in Formula (2)

above, studies with small samples could exert a

much stronger effect on the results than warranted

Wolf (1986) recommends that both the unweighted

and weighted Zc be calculated Therefore, the

Stouffer combined test based on the sample-size

weighted Zc giving more weight to large samples is

calculated as follows (Wolf, 1986: 40):

df

where df is the degrees of freedom associated with

the statistic of each study

Finally, there is a potential problem when

including only published studies While the

manuscript review process helps ensure the quality

of published studies, a publication bias may result

from the tendency that studies with significant

results or larger effect sizes are more likely to be

published than those without significant results or

with smaller effect sizes This problem is commonly

referred to as the ‘file drawer’ problem in that

these unpublished studies are buried away in ‘file

drawers’ (Hay et al., 2006; Wolf, 1986).

To deal with publication bias, in a meta-analysis,

the fail-safe number, N fs, is calculated to show the

number of studies failing to report significant

results that would be needed to reverse a

conclusion about a significant relationship betweenthe dependent and independent variables Usingthe results of the Stouffer combined test, thefail-safe number is computed as follows(Rosenthal, 1991: 261):

analysis The robustness of a significant relationship

as represented by its fail-safe number can becompared with a critical number of studies thatmay be filed away Rosenthal (1991: 262) providesthe following equation for calculating the criticalnumber of studies:

where k is the number of studies in the

meta-analysis According to Clark-Carter (1997)and Rosenthal (1991), the file drawer issue is only

a problem if the fail-safe number is not greaterthan the critical number of studies Moreover,the fail-safe number and the critical number ofstudies only need be calculated for significantrelationships

RESULTSTable 3 reports the main results of the meta-analysis

of the effects of corporate governance and auditquality attributes on earnings management Foreach attribute, we discuss its nature andhypothesized effect on earnings management(earnings quality or lack thereof), and the resultsfrom our meta-analysis

Corporate governance

The role of corporate governance structure of acorporation in financial reporting is to ensurecompliance with GAAP and to maintain thecredibility of corporate financial statements.Common measures of corporate governanceeffectiveness that are the focus of prior research arerelated to the composition, expertise, and activity

of the board of directors (BOD) and its auditcommittee (AC)

BOD independence

Fama & Jensen (1983) recognize the board ofdirectors as the most important management

Table 2: Studies excluded

variable

Different dependent variable

No applicable data

Abbott et al 2006 discretional accruals audit fees

Aboody et al 2005 insider trading

Adjaoud et al 2007 accounting rate of return &

market-based performance

Aier et al 2005 CFO characteristics

Akhigbe et al 2005 abnormal stock return

Arnold et al 2001 additional audit work

Arthaud-Day et al 2006 turnover of CEO, CFO,

BOD and auditcommittee members

Ashbaugh-Skaife et al 2006 credit ratings

Ball & Shivakumar 2005 firm characteristics

Ball & Shivakumar 2006 cash flows & stock

returns

Bartov et al 2001 audit opinions

Beatty & Weber 2006 goodwill writeoff

Beekes et al 2004 reporting conservatism

Blouin et al 2007 selection of new auditors

Braiotta & Zhou 2006 audit committee alignment/

changeBrown & Higgins 2001 earnings surprise

management

Butler et al 2004 auditor opinions

Carcello & Neal 2003 management discussion of

financial distress

Charitou et al 2007 auditor opinions

Chen et al 2001 auditor opinions

different models

Chung & Kallapur 2003 client importance

Davidson & Neu 1993 earnings forecast error

Davidson et al 2006 auditor changes

DeFond & Jiambalvo 1991 accounting errors

DeFond & Park 2001 abnormal accruals

El Mir & Seboui 2006 market value

Filatotchev et al 2005 financial performance

Francis et al 2004 earnings attributes

Gaver & Paterson 2001 loss adjustment

Geiger et al 2005 hiring of former

auditors

Givoly et al 2007 reporting conservatism

Glaum et al 2004 firm characteristics

Table 2: Continued

variable

Different dependent variable

No applicable data

Heninger 2001 auditor litigation

Higgs & Skantz 2006 stock return

Iturriaga & Hoffmann 2005 stock ownership

Jenkins et al 2006 interactive effect of

event and auditorspecialization

main auditorspecializationeffect notreported

Kanagaretnam et al 2007 info asymmetry

Karamanou & Vafeas 2005 earnings forecast

Keasey & McGuinness 1991 earnings forecast

Kim et al 2003 auditor conservatism

Knechel & Payne 2001 audit report lag

Knechel & Vanstraelen 2007 auditor opinions

Koh 2003 institutional

ownership

Lapointe-Antunes et al 2006 voluntary disclosure

clusterwiseregressions; nocontrol variables

loading scoresLee & Mande 2003 private securities

litigation reform act

Leuz et al 2003 investor protection

Matsumoto 2002 firm characteristics

Menon & Williams 1994 audit committee

characteristicsMitra & Cready 2005 institutional

ownership

Palmrose & Scholz 2004 restatement

Peasnell et al 2000 different accrual

models

Phillips et al 2003 deferred tax expense

Pincus & Rajgopal 2002 firm char

Ruddock et al 2006 reporting conservatism

Saleh & Ahmed 2005 debt renegotiation

control mechanism From an agency perspective,

the ability of the board to function as an effective

oversight of management in the areas of financial

reporting rests upon its independence from

management (Beasley, 1996) Therefore, it is

assumed that effective governance and financial

reporting quality increase with board

independence (as measured by the proportion

of outside or independent directors on the board)

A slight majority of prior studies report a

significantly negative relationship between

earnings management and increased BOD

independence (e.g., Beasley, 1996; Klein, 2002)

However, Park & Shin (2004) and Peasnell et al.

(2005) do not find a significant relationship The

meta-analytical results reported in Table 3 show

that independence of the board has a significant

negative relationship (at the 1% level) with

occurrence of earnings management, based oneither unweighted or weighted Stouffer test Also,the fail-safe number greatly exceeds the criticalnumber of studies (2,285 versus 100), hencestrongly supporting the hypothesis that earningsmanagement decreases as the board independenceincreases as suggested by Fama & Jensen (1983)

BOD expertise

While a more independent board may intend torestrain earnings management, only outside orindependent directors on the board with properbackground may be able to do so A director withfinancial expertise may have greater familiaritywith how earnings can be managed and takenecessary measures to curb earnings management.Relatively few existing studies examine this issue

Table 2: Continued

variable

Different dependent variable

No applicable data

Sánchez-Ballesta &

Sánchez-Ballesta &

García-Meca 2007 stock ownershipstructure

Shen & Chih 2005 firm characteristics

reportedSrinivasan 2005 restatement

Summers & Sweeney 1998 insider trading

Teoh & Wong 1993 stock market reaction

unexpected earnings

behaviorVan der Zahn & Tower 2006 auditor fees

Wang 2006 founding family

ownership

Wright et al 2006 firm characteristics

Yeo et al 2002 management stock

ownershipZhao & Millet-Reyes 2007 stock return

committee characteristics or audit quality, or the dependent variable is not based on abnormal accrual, financialstatement restatement or fraud as the measure of earnings management (quality), with the variables actually

used noted in the applicable cells Studies are also excluded when the test statistics, p-value or similar data

needed to compute the effect size for meta-analysis is not reported

One of the studies (Park & Shin, 2004) reports

a significantly negative association between

increased board financial expertise and earnings

management, but another study (Xie et al., 2003)

finds a negative but insignificant relationship

Our meta-analysis results suggest that the board

financial expertise is negatively related to earnings

management (significant at the 1% level) using

either the unweighted or weighted Stouffer

combined test The fail-safe number exceeds the

critical number of studies (38 versus 25),

supporting the negative relationship

BOD stock ownership

A clear theoretical prediction about the effect of

stock ownership by directors on the effectiveness

of the board in monitoring management does not

exist Gul et al (2002: 30) argue that ‘managers

of firms with low director ownership are expected

to respond to accounting-based contracts by

exploiting the latitude available in accounting

procedures to either alleviate constraints or

capitalize on available incentives suggesting a

higher level of earnings management’ In other

words, higher stock ownership by directors will

reduce the occurrence of earnings management

However, a direct financial interest, such as stock

ownership by outside directors, may weaken theindependence of directors and their effectiveness

in monitoring management decisions, including

in the area of financial reporting Prior studiesprovide mixed evidence on the effect on earningsmanagement of directors’ stock ownership in the

firm For example, Gul et al (2002) document

a significantly negative association betweendirectors’ stock ownership and earnings

management In contrast, Peasnell et al (2005)

report a positive, though not significant,association Our meta-analysis suggests nosignificant relationship exists between stockownership by directors and earnings management.Further research is probably warranted

BOD independent chair

Another important characteristic of the board iswhether the position of the Chief Executive Officer(CEO) is separate from the position of thechairperson of the board One of the importantroles played by the chairperson of the board is torun the board meetings and oversee the process

of hiring, evaluating, firing and compensating theCEO Jensen (1993) argues that it creates a conflict

of interest for the CEO to serve as the board chairand perform the oversight function related to this

Table 3: Effect of audit quality and corporate governance variables on earnings management

test using unweighted Z

Stouffer test using weighted Z

Number

of studies

Fail- safe number

Critical number for drawer

Board of Directors (BOD) Independence -4.904*** -4.386*** 18 2285 100

Existence of Audit Committee (AC) -1.254 1.037 6 N/A N/A

Note: ** = significant at the 5% level, *** = significant at the 1% level